Difficult times call for a wise fiscal policy November 07, 2019

Urmas Varblane
Member of the Fiscal Council

People often seem to ask in a surprised tone how it is possible that economic forecasting is not done correctly and is inaccurate. This seems to have been something of a race in recent months between institutions forecasting the performance of the global economy to see who can make their outlook for the coming years bleaker.

A few days ago in Paris the OECD published its interim report on the development of the global economy, warning that the coming years may see a long-lasting period of very low economic growth. It had cut the outlook for growth in advanced industrial countries particularly sharply, expecting growth of only 1% in the euro area in the years ahead for example.

Increased uncertainty plays a very large role in this sharp slowdown of economic growth, and has largely been caused by various political measures behind which can be seen the ideas of populists and their desire to appeal to supporters with simple solutions. The key focus of the campaigns of Donald Trump and Brexit was the demand to give us our country back and the desire to take back control. This is now expressed in a trade war that consumes not just the US and China, but a large share of those involved in the global economy.

It remains unclear in Europe what will happen with Brexit, but it is probable that the news about it for companies will be bad or very bad. It is unclear in the Middle East what resolution there can be to the stand-off between the US and Iran that is putting pressure on the oil price. This uncertainty makes businesses more cautious, and makes them less inclined to expand their activities and invest. All of this heightened political uncertainty works in opposition to the efforts of central banks to revive the economy.

In this stormy environment, the Ministry of Finance produced its summer economic forecast, which will serve as the basis for Estonia's budget for next year. Forecasting the economy is a very difficult task and is largely also a subjective one. A lot depends on which factors are considered and how they are expected to develop.

The forecast of the Ministry of Finance uses certain assumptions about the risks in the external environment and it has reduced its outlook for economic growth for the upcoming year by 0.5% to 2.2%. This is in general a realistic estimate, but the Fiscal Council considers that there are other factors that indicate the slowdown could be even greater.

Global value chains mean that we are very tightly connected to the large economies of the world and slower growth in the global economy affects Estonia quickly, slowing the growth in our exports and so affecting the Estonian balance of payments and growth in the economy. The most recent data on Estonian exports indicate they were 8% down on a year earlier in June and 2% down in July. Problems in energy and mining caused Estonian industrial output to fall so it was 6% lower in June than a year earlier and 5% lower in July.

Unfortunately, the reduced outlook for economic growth will coincide with the need for the government to improve its fiscal position. We have brought this about for ourselves, because when the economy was doing well in recent years we were not able to keep government spending under control. The tax revenues that could be classed as temporary excess revenues have also been spent. The government now faces an obligation to improve the budget each year from the previous year until we have regained structural balance. At the same time the government has a stack of unfulfilled election promises to carry out, all of which require extra spending.

It seems that the budget for next year was only stuck together at the last moment through temporary solutions. It is hoped that some fiscal pressure can be eased in the future by pension reform and faster use of European Union support on the revenue side, and cooperation between the public and private sectors on the expenditure side. A lot of uncertainty surrounds such measures at the moment though.

What should be done to maintain the capacity of the Estonian economy to grow when it is faced with a weakening external environment and a budget that is under pressure? One answer is to invest wisely, and to make preparations so that we would be able to invest at all.

Investment is often a place where savings are made when the budget is under pressure or economic conditions are deteriorating, because it can be postponed, reduced or abandoned. Investment should however be the last place to look for savings that can be used to fund election promises. Unfortunately the initial estimate suggests that the investments planned for 2020 will indeed be lower than those in previous years.

Where should investment be directed? Infrastructure is always important, through investment in roads and the like. If companies are not confident enough to invest, the state can offer support. Road construction cannot be started or slowed down at the drop of a hat though whatever the position of the economic cycle. For this reason a lot has been said about doing all the preparatory work so that road construction could be increased to the necessary degree, and within the limits of the budget, at the appropriate moment.

Another specific example that was recommended after the last economic crisis and that the Stockholm Environment Institute is now recommending is to invest in improving the insulation of housing. Unlike road construction, this can be done in a very flexible way and it brings benefits to all of society through lower energy consumption and reduced carbon emissions.

A longer term direction would be to invest in research and development activity and in increasing the capacity for it. This is not simply a question of boosting spending on research and development to 1%. The main problem that faces our economy is not the question of how better to share, but how to create new value. It is not enough that we just get angry about why our companies are not as innovative as those in Finland or Sweden. Experience has shown that no country has achieved sustainable success without the state providing strong and well thought out support for making society more knowledge-based.

This raises the question of where those investments are that are needed to encourage our companies to raise their technological capacity, update their knowledge bases, and look for partners to cooperate within our own universities and in foreign ones. What became of the idea of setting up an innovation agency at Enterprise Estonia? This is really a question of priorities, and our discussions about moving to a knowledge-based economy will remain nothing but empty words if they are not reflected in the budget.

Published: 27.09.2019
Published in: Postimees